The Muni Bond Market Signals Danger Ahead

Municipal bond issuance dropped to an 11-year-low in January. It has not picked up substantially in February, according to the muni bond people I speak to.

January saw $12.2 billion of new debt, a decline of nearly 63 percent from January 2010. Volume hasn’t been this low since January of 2000.

The standard explanation for this is the end of the Build America Bond program, which offered qualified issuers a 35 percent federal tax subsidy to issue taxable debt.

But the BABs—the bonds' colloquial name—accounted for just 24 percent of the $757.6 billion of state and local debt issued from April 2009 through last month. So obviously, the decline goes much further than the end of the BAB program would warrant.

The muni bond people say that the excess decline comes from front-loading that occurred in the end of 2010, as issuers rushed to get BABs in before the program died. There’s some evidence for this: issuance spiked as the program neared its end, totaling $133.8 billion for the fourth quarter, the second-highest quarterly volume ever.

Some say that issuers are holding for a more borrower-friendly market. Yields on triple A-rated 10-year munis reached a 24-month high of 3.46 percent in mid-January, according to The Bond Buyer. Many states and cities seem to think that they can wait out the high-yield environment.

This could be a dangerous game. It has the potential to result in a pent-up demand for credit. If yields remain elevated for long enough, borrowers could find themselves forced to come to market when everyone else is also trying to sell bonds. This surge would likely push down prices and raise yields even further.

We’ve heard this kind of talk about “temporary market dislocations” before—back when the market for mortgage-backed securities began to fall apart in 2007 and 2008. There was lots of confident talk back then, about market prices not reflecting fundamentals and too much risk being priced into mortgage bonds. As it turned out, market prices were accurately reflecting the climb in mortgage delinquencies and decline in revenue streams from the bonds.

A far less benign explanation for the decline of issuance could be that the muni market is freezing up. We’ve now seen month after month of outflows from muni funds, forcing funds to sell bonds to pay off exiting investors. It’s very likely that some of the decline of issuance results from advice from bankers, who fear they cannot sell the bonds at yields attractive to the borrowers.

The mortgage-backed security market froze up in a similar way prior to the finance crisis. Take a look at the chart above, which shows the decline of private label mortgage backed securities that began in mid-2006. That decline, as it turned out, anticipated a huge jump in mortgage defaults.

It might make sense to take another look at the effect of the BABs. Instead of seeing the end of the program as an explanation for this decline, I can look at the beginning of the program as an artificial boost to the market. Without BAB, the evidence of trouble in the muni market may have been apparent even earlier.

I don’t think that the muni market is transparent enough to allow for accurate forecasting—which is why I’m not predicting a surge of defaults. But I do think it makes sense to watch for potential warning signs in the market—and the dramatic drop in issuance could well be flashing: DANGER AHEAD.